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Notice 2010-6: Sec. 409A Document Failure Correction Program

On January
5, 2010, the IRS issued Notice 2010-6, which provides methods
for taxpayers to voluntarily correct certain types of failures
to comply with the document requirements of Sec. 409A. This
correction program is intended to encourage taxpayers to
review nonqualified deferred compensation (NQDC) plans for
Sec. 409A document failures. The notice addresses eligibility
and provides methods for correcting plan provisions that do
not comply with Sec. 409A(a) plan document requirements.

In some cases, plans may be corrected without service
providers having to include amounts in income under Sec. 409A,
while in other cases as much as 50% of the amount deferred
under the plan must be included in income, subject to the 20%
additional income tax rate (although not the additional
premium interest tax). In addition, taxpayers taking advantage
of the correction program are generally required to attach a
statement to their tax returns. Correction under the notice
isolates the document failure to the year of correction so
that the failure will not taint prior years.

Effective Date

Taxpayers may rely on
Notice 2010-6 for tax years beginning on or after January 1,
2009. The modifications to Notice 2008-113 are effective for
service provider tax years beginning on or after January 1,
2010, but may be relied upon for service provider tax years
beginning before that date.

In particular, if a plan
is eligible for correction under this notice and is corrected
on or before December 31, 2010, the plan may be treated as
having been corrected on January 1, 2009. Furthermore, any
income inclusion that would otherwise be required is waived,
provided that any payment made before December 31, 2010, that
would not have been made under the amended provision (or any
payment not made before December 31, 2010, that would have
been made under the amended provision) is treated as an
operational failure and fully corrected in compliance with all
the requirements of Notice 2008-113 on or before December 31,
2010.

The modifications to Notice 2008-115 are
generally effective for service provider tax years beginning
on or after January 1, 2009, provided that the modifications
to Notice 2008-115 that are due to changes to Notice 2008-113
are effective for service provider tax years beginning on or
after January 1, 2010, but they may be relied upon for service
provider tax years beginning before that date.

Treasury and the IRS are requesting comments about other
document failures that commonly occur and methods to correct
them. Comments must be submitted by April 5, 2010.

General Requirements

To be eligible for relief
under Notice 2010-6, the taxpayer must satisfy general
eligibility requirements (other than with respect to certain
ambiguous terms, as discussed below), requirements for a
particular correction method, and information and reporting
requirements of the notice. The taxpayer has the burden of
demonstrating eligibility for relief and that each of the
notice’s requirements has been satisfied. A taxpayer’s
eligibility for relief is subject to examination by the IRS.

If a service recipient has identified and corrected a
document failure in an NQDC plan, the service recipient must
take commercially reasonable steps to:

Identify all other NQDC plans that have a document
failure that is substantially similar to the one initially
identified and corrected, even if the affected service
provider does not participate in the other plan; and

Correct all failures consistent with Notice 2010-6.

The plan aggregation rules do not apply to the
written plan requirements. As a result, these rules do not
apply to correction of document failures under similar plans
unless the plan has a similar document failure.

Relief
is not available to service providers and service recipients
that are under examination before correction is complete. An
individual service provider or service recipient is treated as
under examination for NQDC if the individual’s federal income
tax return is under examination. A nonindividual service
provider or service recipient is treated as under examination
if the service provider or service recipient receives written
notification (for example, by examination plan, information
document request, or notification of proposed adjustments or
income tax examination changes) from an examining agent
specifically citing NQDC as an issue under consideration. For
corrections prior to December 31, 2011, a nonindividual
service recipient will be treated as under examination only if
the specific document failure has been identified on
examination.

Relief is not available for intentional
failures or failures that are directly or indirectly related
to participation in any listed transaction under Regs. Sec.
1.6011-4(b)(2).

In addition to the general
requirements, the notice addresses issues such as coordination
of multiple failures and how to measure the amount of income
to be included, to the extent required.

Eligible
Document Failures

If the taxpayer meets all the
eligibility requirements, the following corrections are
available for the specified document failure:

Ambiguous plan terms: These are terms that are
undefined or have an ambiguous definition relative to the
requirements of Sec. 409A. If plan operation is consistent
with Sec. 409A, no amendment is required, although a
taxpayer may decide to amend these provisions to eliminate
the ambiguity. On the other hand, if the facts and
circumstances indicate that a service recipient has
intentionally used the ambiguous term to pay amounts, the
plan and any other plan of the service recipient with the
same or substantially similar language (regardless of
whether the plans include any of the same service providers)
will not be eligible for relief.

As soon as reasonably practicable: An ambiguous
plan term includes a provision for payment to be made
“as soon as reasonably practicable” upon a Sec. 409A
permissible payment event, or it provides similar timing
language. If a plan includes this language and payments
are made in compliance with Sec. 409A (i.e., no later
than the end of the service provider’s tax year in which
the event occurs or the fifteenth day of the third month
following the month in which the event occurs), the
provision would not fail to satisfy the Sec. 409A(a)
requirements. If the payment is made after this period,
the failure is an operational failure, unless the
service provider can demonstrate that the delay
qualifies for a timeliness exception (for example,
payment would have jeopardized the service recipient’s
ability to continue as a going concern).

Ambiguous payment event definitions: An
ambiguous plan term also includes a plan provision that
designates a payment event, but it does not define the
event or has an ambiguous definition of the event
relative to compliance with Sec. 409A. Note that if the
plan states that terms are to be interpreted in a manner
consistent with Sec. 409A, the term is not considered
ambiguous.

An ambiguous
payment event will not cause a plan to fail to satisfy
Sec. 409A(a). If a payment is made that does not comply
with Sec. 409A, this may be treated as an operational
failure eligible for relief under Notice 2008-113,
provided the plan is amended before the end of the
service provider’s tax year during which the operational
failure is corrected in accordance with Notice 2008-113.
The amendment may either add language to require the
provision to be interpreted in accordance with Sec.
409A(a) or set forth definitions that comply with Sec.
409A. The amendment may not expand the definition to add
or eliminate payment events that were not available
before the amendment.

This
relief is not available if (1) the provision has been
interpreted by the service recipient, on or after
January 1, 2009, through its pattern or practice of
administering the plan, or (2) a court with jurisdiction
over enforcement of the contract has interpreted the
provision. Instead, the term is considered an
impermissible definition of an otherwise permissible
payment event (see below).

Impermissible definition of otherwise permissible
payment event: Plan provisions that provide for
payment upon separation from service, change in control, or
disability based on definitions that do not comply with Sec.
409A may be eligible for relief if the plan is amended
before the date the event occurs. The amendments must be
effective immediately. In general, the amendments cannot
provide for payment events that were not available before
the correction; however, relief to correct payments on
disability allows a payment event to be removed entirely.

In the case of payments upon
separation from service or change in control, the correction
may be made without income inclusion if an event that would
have been a payment under the pre-amendment plan, but not
the corrected plan, does not occur within one year following
the date of correction. If such an event does occur within
one year following the date of correction, then in the tax
year in which the event occurs, the service provider must
include in income, and the service recipient must report, an
amount equal to 50% or 25% of the amount deferred in the
case of separation from service and change in control,
respectively. These amounts are subject to the additional
20% income tax but not the premium interest tax. If the plan
provision is not corrected before the event occurs, the plan
would fail to satisfy Sec. 409A for the year of the event
and all previous years in which the plan contained the plan
provision.

There is a special rule for
payments upon disability if the provision is corrected after
the event. In this case, the plan may be corrected
retroactively if any amount paid on an event that would not
qualify as a disability under Sec. 409A is corrected as an
operational failure under Notice 2008-113.

Impermissible payment period following a permissible
payment event: A plan that provides for a Sec. 409A
compliant payment event but provides for payment more than
90 days following the event, or allows the service provider
to choose the tax year of payment, may be corrected by
amending the plan either to remove the payment period or to
set forth a compliant payment period. If the plan is not
amended before the event but is amended a reasonable time
after the event occurs, the plan would be treated as failing
to comply with Sec. 409A(a), and the affected service
provider must include in income 50% of the amount deferred
under the plan in the tax year of the service provider
within which the permissible payment event occurred, with
that amount subject to the additional 20% income tax.

Relief is also available for payments upon
permissible events that are conditioned upon
employment-related actions of the service provider, such as
execution and submission of a noncompetition or
nonsolicitation agreement or a release of claims. The plan
must be amended before the event occurs to (1) remove the
provision, (2) provide that payments will be made on the
last day of the payment period if a period is designated, or
(3) if a period is not designated, provide that payments
will be made either 60 or 90 days following the event. The
amendment may not otherwise change the time or form of
payment. If the provision is not corrected before the event,
the affected service provider would be subject to Sec. 409A
income inclusion, 20% penalty, and premium interest tax.

Impermissible payment events and payment schedules:
Notice 2010-6 offers relief for plans that provide for
payment upon permissible and impermissible payment events,
plans that have only impermissible events, certain
impermissible alternative schedules, and impermissible
reimbursement or in-kind benefit provisions. Relief is also
available for provisions that afford service recipients and
service providers impermissible discretion to change a
payment schedule or make subsequent deferral elections, and
provisions that give service recipients discretion to
accelerate payments. These failures may be corrected before
the event occurs by an amendment that is immediately
effective. In some cases, if an event that would have been a
payment event under the terms of the pre-amendment plan, but
not under the plan as corrected, occurs within one year of
the date of the correction, the service provider must
include 50% of the deferred amount in income in the tax year
of the service provider within which the payment event
occurred, subject to the additional 20% income tax.

Failure to include the six-month delay: If a plan
fails to include a provision for the six-month delay for
payments upon separation from service to specified
employees, relief is available if the plan is amended before
the event occurs. The amendment must add the six-month delay
and provide that payments subject to the delay will not be
paid before the later of (1) 18 months following the date of
correction or (2) six months following the date of the
payment event. If these requirements are satisfied, the
amendment will not be treated as a subsequent change in time
or form of payment. If an employee has a separation of
service within one year of the date of correction and the
provisions of the corrected plan result in a deferral
relative to the pre-amendment plan, the service provider
must include in income 50% of the amount deferred under the
plan in the service provider’s tax year within which the
separation from service occurs, subject to the additional
20% income tax.

Impermissible deferral elections: Relief is
available for initial deferral elections that do not comply
with Sec. 409A(a). This relief does not apply to elections
as to time and form of payment because relief for certain of
these failures is available in other sections of Notice
2010-6. If a noncompliant initial deferral election is
revoked prior to the Sec. 409A deadline for making an
initial deferral election, the service provider is not
required to include amounts in income under Sec. 409A. The
plan must be corrected no later than the end of the service
provider’s second tax year immediately following the tax
year during which the applicable deadline for making an
initial deferral election under Sec. 409A expires. Amounts
subject to the noncompliant deferral elections must be
corrected in accordance with Notice 2008-113, which may
require income inclusion under Sec. 409A. The relief for
this correction does not have retroactive effect on amounts
deferred in previous years that are subject to noncompliant
deferral elections. As a result, the plan document failure
remains for previous years, and any resulting deferral will
remain an operational failure. The service recipient must
take commercially reasonable steps to identify and correct
similar provisions in all of its plans.

Amendment period following a service recipient’s initial
adoption of a plan: Notice 2010-6 provides relief for
certain new plans that have a document failure within the
first year the legally binding right to deferred
compensation was established. A plan provision is eligible
for relief under the notice if the plan is amended, and any
payments are treated as operational failures and corrected
under Notice 2008-113 by the end of the calendar year in
which the document failure is corrected. The plan must be
amended by the later of the end of the calendar year in
which, or the fifteenth day of the third calendar month
following the date, the first legally binding right to
deferred compensation arose under the plan and all other
plans that may be aggregated with the plan if a single
service provider participated in all of the plans. For these
purposes, the provisions of Notice 2010-6 will be applied
without applying the requirement of income inclusion if an
event occurs within one year of the date of correction.

Stock Rights and Linked Nonqualified Plans

Notice 2010-6 does not provide relief for stock rights
or plans where the time and form of payment under an NQDC plan
is linked to one or more other NQDC plans or one or more
qualified plans. Certain relief for discounted stock rights is
set forth in Notice 2008-113. The notice provides transition
relief for corrections made on or before December 31, 2011,
with respect to linked NQDC plans and payment schedules
determined by the timing of payments received by the service
recipient. Generally, if any amounts have been paid under the
plans under the pre-amendment provisions since January 1,
2009, or inconsistent with the amended provisions, these
amounts must be treated as operational failures and corrected
under Notice 2008-113.

Changes to Notices 2008-113
and 2008-115

The notice also modifies several
provisions of Notices 2008-113 and 2008-115. In particular,
the modifications clarify treatment of correction of
distributions involving transfers of stock or other property
and coordination of repayment with adjustments to withholding.

Notice 2008-113: This notice is modified to provide
that if relief requires a service provider to repay amounts,
the service provider may repay the net amount received after
any withholding to the extent the service recipient has made
a correction (such as an adjustment made on a Form 941-X,
Adjusted Employer’s Quarterly Federal Tax Return or Claim
for Refund) to recover the amount of taxes withheld on the
amount erroneously withheld. In lieu of repayment, the
service recipient may reduce other compensation due to the
service provider, provided the other compensation is
included in income. An amount is not treated as repaid if,
in connection with repayment, the service recipient pays or
provides the service provider a benefit intended to replace
the repaid amounts.

Notice 2008-113 has
been modified to address how to determine the repayment
amounts in the event of an operational failure involving
amounts that were erroneously paid or deferred in the form
of property (such as stock). The amount that must be repaid
equals the fair market value of the property at the time of
the erroneous payment. Any difference between the fair
market value at the time of the erroneous payment and at the
time of repayment is treated as earnings or losses in
accordance with the applicable section of Notice 2008-113.
If the amount erroneously deferred was set as a dollar
amount, the deferral equals the dollar amount. If the amount
of the erroneous deferral was based on certain property, the
amount of the deferral equals the fair market value of the
property at the time it would have otherwise been payable
had the deferral not occurred. Relief for operational
failures involving excess deferrals corrected in the tax
year following the year of the failure has been changed to
include failure to pay amounts during the year in which the
original payment date occurred.

Notice 2008-115: If a taxpayer is entitled to
relief under Notice 2010-6, Notice 2008-115 is modified to
conform to the provisions of Notice 20106, including
modifications to Notice 2008-113, with respect to the amount
required to be included in income by a service provider
under Sec. 409A and the amount of Sec. 409A income that is
required to be reported by a service recipient.

Conclusion

In general, Notice 2010-6 provides
significant relief with respect to potential document failures
by allowing correction in one year to address failures in
prior years. This notice and Notice 2008-113 give taxpayers
many opportunities to address noncompliance in advance of an
IRS examination. Audit activity related to Sec. 409A has
commenced, and individuals with noncompliant compensation are
sometimes receiving notices. Thus, it is important for all
taxpayers to review their arrangements to uncover any
noncompliance.

While the notice provides welcome
relief, it does require significant income inclusion in some
cases based on post-amendment events, which may affect service
providers with similar issues differently for reasons outside
the control of the service provider. Similarly, the notice
imposes requirements on the service recipient, such as
consistency in corrections that are outside the control of the
service provider. Treasury and the IRS have requested
comments, which can be expected to address these issues, among
others.

EditorNotes

Jon Almeras is a
tax manager with Deloitte Tax LLP in Washington, DC.

This article does not constitute tax, legal, or other
advice from Deloitte Tax LLP, which assumes no
responsibility with respect to assessing or advising the
reader as to tax, legal, or other consequences arising from
the reader’s particular situation.

Unless otherwise noted, contributors are members of or
associated with Deloitte Tax LLP.

For
additional information about these items, contact Mr. Almeras
at (202) 758-1437 or jalmeras@deloitte.com.

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